FIRE 623 Graded Case Assignment - Mid-Atlantic Container Corporation 100 points Due December 4, 2019 at 7:00 pm 1) Assess the current financial health and recent financial performance of the company. What strengths and/or weaknesses would you highlight to Sarah Conner? 2) What are the key driver assumptions of the firm's financial performance? What are the managerial implications of those key drivers? That is, what aspects of the firm's activities should Sarah Conner focus on especially? What is Mid-Atlantic's weighted average cost of capital (WACC)? What are the key assumptions that especially influence WACC? What are the free cash flows of the packaging machine investment? Should Conner approve the investment? Forecast the firm's financial statements for 2018 and 2019. What will be the external financing requirements of the firm in those years? Can the firm repay its loan within a reasonable period? Hint: You should analyze the packaging machine investment before forecasting the financial statements. NOTES: I am more interested in the quantitative analysis. Thus, your write-up should be (a) concise and to the point and (b) based on your quantitative analysis. The write-up should not exceed three (3) pages plus how ever many pages you need for your spreadsheet analysis. Make sure that I am able to follow your spreadsheets. That means to annotate and format appropriately. Your grade will be partly based on how you present the data to me. You may work in groups of up to 4 people on this project. EXHORT Historical income Statements scal year ended June 30. ligures in thousands of dollars) 2016 2017 2018 2019 Actual Actual Actual Actual $25 202 $28822 $34010539792 1 Sales Operating Expenses 2 Production costs and expenses 3 Administrative and selling expenses Deprecanon Total operating expenses 11 950 13.30 17.847 22335 5.734 5.957 7020 7.970 2375 2,367 2687 2,657 120 060) (21,714) (27 534) (32.972) 52 7 109 646682 (2427) 2.535) 3265) (3.222) 3.715 4574 3212 3.598 (1.647) (1 845) (1.269) (1.403) 2.000 2720 1943 2.195 1000 1000 1000 1000 $1.068 $1.7293943 1.195 3 E ings before the to common shares EXHIBIT 2 Historical Balance Sheets fiscal year ended June 30, gures in thousands of dollars) 2016 2017 2018 2019 (Actual) Actual Actual (Actual Assets $1.754 32040 $2.906 $1.540 2 Accounts receivable 8.113 9,125 10 311 13.316 15,851 17.147 25.043 34.717 4 Total current assets 25.738 28 312 38 859 49.573 5 Gross property plant & equit 23 567 28 687 20 657 28.867 5 Accumulated depreciation (2 505) (4372) 7.538) (10.205) 7 Net property plant seguit 21 162 21.796 19.129 18.462 Total assets 46.900 50.107 67 988 68.035 Liabilities and stockholders' equity 9 Short term borrowings (bank) 10 Accounts payable 11 Other current abilities 12 Total current liabilis 13 Long term deb 14 Shareholders' equity 15 Totlabs & Shir'e 12.000 13.042 19 680 25 802 4511 4,607 4,705 5328 9.0149414 9616 9723 25,585 27.083 34001 40 853 10.000 10000 10000 10 000 11.315 13.044 13987 15 182 $40 900 950 107 $57 988 586 035 Short-term bank debt ws borrowed from Yurbank at an interest rate equal to LIBOR 4 percent LIBOR (London Interbank Offered Rate) was a common benchmark for expressing the floating rate of interest on bank loans ** The company's long-term debt of $10 milion had been issued pively in 2015 to Bendini Lambert and Locke and to Carolina Pulp & Paper. This debt was subordinate to any bank debt outstanding EXHIBIT 3 Ratio Analysis of Historical Financial Statements (fiscal year ended June 30) 2016 (Actual) 2017 (Actual) 2018 Actual) 2019 (Actual) Profitability 1 Operating Profit Margin 2 Average Tax Rate 3 Return on Sales 4 Return on Equity 5 Return on Assets 23.4% 44.3% 7.9% 18 3% 4.4% 24.7% 40.3% 9.5% 20.9% 5.4% 19.0% 39.5% 5.7% 13.9% 3.4% 17.1% 39.0% 5.5% 14.5% 3.3% Leverage 2.36 6 Debt Equity Ratio 7 Debt/Total Assets 8 EBITAnterest (x) 1.95 0.47 2.53 1.77 0.46 2.80 2.12 0.51 1.98 0.54 2.12 Asset Utilization 9 Sales/Assets 10 Sales Growth Rate 11 Assets Growth Rate 12 Days in Receivables 13 Payables to COGS 14 Inventories to COGS 55.9% 40% 6.0% 113.0 37.7% 132.7% 57.5% 100% 6.8% 115.6 34.4% 128 2% 58.7% 18.0% 15.7% 110.7 26.4% 143.7% 60.3% 17.0% 13.9% 122.1 23.9% 155.4% Liquidity 15 Current Ratio 16 Quick Ratio 1.01 0 39 1.05 0.41 1.14 0.39 1.21 0.36 EXHIBITS Datson Com b ie Comories and Carital Market Conditions of Sales Cardboard B Name Dickensonic Nbre MS Pranings Valueline Book Book Value Price Outstanding Det er Share on Sharmillions 550 S10 DO 50 1.30 070 1275 18.00 15 0 2000 25 CO 000000 5-Year Arms Earrings Grow Dand 50 95 $100 305 5000 52.20 Don ISBEX Carp ZEPORT Recently Renes s 2019 Coco Mar Camcunda Price LO US Trys US Treasury Bills US Treasury His US Treasury Bill US Toy Bonds US Treasury on 2016 year 5 year Semana Dickerson le Han beshe Donaldson no 000x Corp REPORT 50% 604 150 2 2020 2031 10.04 9341 01.08 9031 30 Historical Fury Note Face value on all bonds Premium 100 Amor Me Gemeen Desconal Companes Dickerson me The company was founded 50 years ago you can Detot no major business actores enorcaty have been production of packsong cacer trycy entered the candid chan Han hal This company was a sis off from a large conglomerate in 1978 Although the many we d er in the producton of cardboard boves the recent suffered decline in sales infighting among the prinopal owners has lod concern about the forme prospects Donde They founded only two w ere sa com and its s e is about the same t h of carbon IBEX Corp This company has recenty been an innovator in the production of cardboard Amough c heard box a tacuring is not a business paper bag manucuring the company is reeds beam competitor in the next The company was an early poneer in the cardboard box nauntry Recently however began to invest in now areas and has been moving away from cardboard production is a focus of business ZEPORT Mid-Atlantic Container Corporation: Some Financial Concerns On August 25, 2019, her first day as chief executive officer (CEO) of Mid-Atlantic Container Corp. (Mid-Atlantic, Sarah Conner confronted a host of management problems at the company. One week earlier, Mid-Atlantic's president and CEO had been killed in a tragic accident. Soon thereafter, Sarah was appointed to fill the position - starting immediately. Several issues in her in-box that first day were financial in nature, either requiring a financial decision, or with outcomes that would have major financial implications for the firm. That evening. Conner asked to meet with her assistant, Louis Tane, to begin addressing the most prominent issue MID-ATLANTIC CONTAINER CORPORATION AND THE CARDBOARD BOX AND CONTAINER MANUFACTURING INDUSTRY The Mid-Atlantic Container Corporation had been founded as a joint venture between Carolina Pulp & Paper and a venture capital firm. Bendini, Lambert and Locke (BLL) Mid-Atlantic's sole business mission was to manufacture boxes from cardboard packaging known as corrugated Fiberboard. Mid-Atlantic served as a supplier of cardboard boxes to other manufacturing firms in the Eastern US. and was known for producing some of the best cardboard packaging material in the industry Given its ubiquity in packaging, revenue for the global cardboard box and container manufacturing industry is highly correlated with global demand from manufacturing and retail sectors. The industry is highly fragmented with an estimated 15,700 companies operating in the industry (globally) and only 4 companies controlling more than 1.0% of the market. The majority of companies operate locally or regionally, providing cardboard boxes to companies within a relatively short distance from their facilities. Barriers to entry are relatively low: a new, small plant would cost between $8 million and $10 million. Easy entry had led to price competition in recent years among cardboard box manufacturers. One analyst said, The gross margins on cardboard boxes have eroded tremendously over the past five years. I don see there's any more manenvering left on the price. Despite deteriorating demand in the overall US market for cardboard packaging material. Mid-Atlantic's growth prospects looked bright. At the regional level, demand was strong and Mid-Atlantic's focus on customer service and quality products had resulted in a strong and expanding customer base. FINANCIAL QUESTIONS FACING SARAH CONNER That evening, Conner met with Louis Tang, a promising new associate whom she had brought along from BLL. Sarah's brief discussion with Louis went as follows: Sarah Back at BLL we looked at Mid-Atlantic as one of our most promising venture capital investments. Now it seems that such optimism may not be warranted - at least until we get a solid understanding of the firm's past performance and its forecasted performance. Did you have any success on this? Louis Yes, the bookkeeper gave me these: the historical income statements Exhibit 1 and balance sheets Exhibit 2) for the last four years. The accounting system here is still pretty primitivellowever, I checked a number of the accounts, and they look orderly, Sol suspect that we can work with these figures. From these statements, I calculated a set of diagnostic ratios Exhibit 31. Sarah: I see you have been busy. Unfortunately, I can't study these right now. I need you to review the historical performance of Mid-Atlantic for me, and to give me any positive or negative insights that you think are significant Louis When do you need this? Sarah At 7:00 A.M. tomorrow. I want to call our banker tomorrow morning and get an extension on Mid-Atlantic's loan. Louis: The banker, Mr. Farmington, said that Mid-Atlantic was "growing beyond its financial capabilities." What does that mean? Sanak: It probably means that he doesn't think we can repay the loan within a reasonable period. I would like you to build a simple financial forecast of our performance for the next two years ignore seasonal effects and show me what our debt requirements will be at the fiscal years ended 2020 and 2021. I think it is reasonable to expect that Mid-Atlantic's sales will grow at 15 percent each year. Also, you should assume capital expenditures of $8.4 million for plant renovations spread out evenly over the next two years and depreciated over five years on a straight-line basis. Use whatever assumptions seem appropriate to you based on your historical analysis of results. For this forecast, you should assume that any extemal funding is in the form of debt. Louis: But what if the forecasts show that Mid-Atlantic cannot repay the loan? Sarah: Then we'll have to go back to Mid-Atlantic's owners, BLL and Carolina Pulp & Paper for an injection of equity. Of course, BLL would rather not invest more funds unless we can show that the retums on such an investment would be very attractive, and/or that the survival of the company depends on it. Thus, my third request is for you to examine what returns on book assets and book equity Mid-Atlantic will offer in the next two years and to identify the "key driver" assumptions of those returns. Finally, let me have your recommendation about operating and financial changes I should make based on the historical analysis and the forecasts. Louis: The plant manager revised his request for a new packaging machine and thinks these are the right numbers (see the plant manager's memorandum in Exhibit 4) Essentially, the issue is whether to invest now or wait three years to buy the new packaging equipment. The new equipment can save significantly on labor cost but carries a price tag of Si million. My hunch is that our preference between investing now versus waiting three years will hinge on the discount rate. Sarah [laughing) The joke in business school was that the discount rate was always 10 percent. Benedini, Lambert and Locke owned a 60 percent interest in the equity of Mid-Atlantic and Carolina Pulp & Paper owned the remaining 40 percent interest. EXHIBIT 1 Historical Income Statements (fiscal year ended June 30; all figures in thousands of dollars) 2016 2017 2018 2019 (Actual) (Actual) (Actual) (Actual) $26,202 $28,822 $34,010 $39.792 Sales Operating Expenses: Production costs and expenses Administrative and selling expenses Depreciation Total operating expenses Operating income Interest expense Earnings before taxes Income taxes Net earnings Dividends to all common shares Retention of earnings 11,950 5,734 2,376 (20.060) 6,142 (2.427) 3,715 (1.647) 2,068 1.000 $1,068 13.380 17.847 22,335 5,967 7,020 7.970 2,367 2,667 2,667 (21.714) (27.534) (32,972) 7.109 6,476 6,820 (2,535) (3,265) (3.222) 4,574 3,212 3,598 (1,845) (1,269) (1.403) 2.729 1.943 2,195 1.000 1.000 1.000 $1,729 $943 $1,195 EXHIBIT 2 Historical Balance Sheets focal year ended une 30 ml figures in thousands of dollars) (Actual) Actual Actual (Actual Assets Cash Accounts recevable Inventions Total current assets Gross property at & equit Accumulated deprecation Net property plant Beguit To assets $1.754 52000 52.905 51 540 3.113 125 10 311 13 316 15 851 17,147 25 543 34 717 25 738 28.312 38 85949573 23.667 26.687 25 687 25.667 2 505) (4 872) 7.538) (10.205) 21.162 21.795 19.129 16,462 46.900 50.10757.958 66035 Labtes and stockholders' equity Short term borrowings (bank) Accounts payable Other current liabilities Total current liabilities Long term debi Shareholders' equity Total labs & strids'eg 12.060 4,511 9.014 25 585 10.000 11.315 $46 900 13.042 19,680 25.802 4.607 4.705 5.328 9.414 9.616 9.723 27 063 34 001 40.853 10.000 10000 10000 13.044 13 987 15.182 $50,107 $57.968 566,035 Short-term bank debt ws borrowed from Yurbank an interest rate equal to LIBOR 4 percent. LIBOR (London Interbank Offered Rate) was a common benchmark for expressing the floating rate of interest on bank loans ** The company's long-term debt of $10 million had been issued privately in 2015 to Bendini, Lambert and Locke and to Carolina Pulp & Paper. This debt was subordinate to any bank debt outstanding EXHIBIT 3 Ratio Analysis of Historical Financial Statements (fiscal year ended June 30) 2016 2017 (Actual) [Actual) 2018 2019 Actual) (Actual) Profitability 1 Operating Profit Margin 2 Average Tax Rate 3 Return on Sales 4 Return on Equity 5 Return on Assets 23.4% 44.3% 7.9% 18.3% 4,4% 24,7% 40,3% 9.5% 20,9% 5,4% 19.0% 39.5% 5,7% 13.9% 34% 17.1% 39.0% 5,5% 14,5% 3,3% Leverage 6 DebvEquity Ratio 7 Debt Total Assets 8 EBIT/Interest (x) 1.95 0.47 2.53 1.77 0.46 2.80 2.12 0.51 1.98 2.36 0.54 2.12 Asset Utilization 9 Sales/Assets 10 Sales Growth Rate 11 Assets Growth Rate 12 Days in Receivables 13 Payables to COGS 14 Inventories to COGS 55.9% 4.0% 6,0% 113.0 37.7% 132.7% 57,5% 10.0% 6.8% 115.6 34,4% 128.2% 58.7% 18.0% 15,7% 110.7 26.4% 143.7% 60.3% 17.0% 13.9% 122.1 23.9% 155.4% Liquidity 15 Current Ratio 16 Quick Ratio 1.01 0.39 1.05 0.41 1.14 0.39 1.21 0.36 EXHIBIT 4 O'Rourke's Memo Re: New Packaging Equipment MEMORANDUM FROM Sa Corr. President and CEO Mid-Atlantie Container Corporation Haney O'Rourke. Plant Manager August 10, 2019 New Packaging Equipment SUBJECT: Abhough our hox packagun equipment is adeguale al current production levels, it is terribly inefficient The new machinery on the market can give us significantlabor savings as well as increased flexibility with expect to the type of packaging I recommend that we go with the new technology. The considerations relevant to the decision are included in this memo Our current packaging equipment was purchased five wars ago as used equipment in a liquidation sale of a small company. Although the equipment was inexpensive, it is slow, requires constant monitoring, and is frequently shut down for repairs. Since the packagine quipment is significantly slower than the production equipment, we routinely have to use overtime labor to allow packaging to catch up with production. When the packager is down for repairs, the problem is acerbated and we may spend several two-shin days catching up with production. I can say that we have missed any deadlines because of packaging problems, but it is a constant concern around here and things would run a lot smoother with more reliable equipment. In FY 2020 we will pay about $5.000 per year for maintenance costs. The operator is paid $30,000 per year for his regular time, but he has been averaging $40,000 per year because of the overtime he has been working. The equipment is on the tax and reporting books at $120,000 and will be fully deprecated in three years' time (we are currently using the straight-line depreciation method for both tax and reporting purposes and will continue to do so. Because of changes in packaging technology, the equipment has no market value other than its worth as scrap metal But its scrap value is about equal to the cost of having it removed. In short, we believe the equipment has no salvage value at all. The packaper offers many advantages over the current equipment. It is faster, more reliable, more flexible with respect to the types of packaging it can perform and will provide enough capacity to cover all our packaging needs in the foreseeable future with suitable maintenance, we believe the packager will operate indefinitely. Thus, for the purposes of our analysis, we can assume that this will be the last packaging equipment we will ever have to purchase. Because of the anticipated growth at Mid-Atlantis, the current equipment will not be able to handle our packaging needs by the end of 2022. Thus, if we do not buy new packaging equipment by this year's end, we will have to buy it after three years time anyway. Since the speed, capacity and reliability of the new equipment will eliminate the need for overtime labor, we feel strongly that we should buy now rather than wait another three years The new equipment currently costs sl million, which we would depreciate over 10 years $100.000 per year. It comes with a lifetime factory maintenance contract that covers all routine maintenance and repairs at a price of $2.000 for the initial year. The contract stipulates that the price after the first year will be increased by the same percentage as the rate of increase of the price of new equipment. Thus, if the manufacturer continues to increase the price of new packaging equipment at 5 percent per annum as it has in the past, our maintenance costs will rise by 5 percent also. We believe that this sort of regular maintenance should ensure that the new equipment will keep operating in the foreseeable future without the need for a major overhaul. Mid-Atlantic's labor and maintenance costs will continue to rise due to inflation at approximately 2 percent per year over the long term. Because the manufacturer of the packaging equipment has been increasing its prices at about 5 percent per year, we can expect to save $157,625 in the purchase price by buying now rather than waiting three years. The marginal tax rate for this investment would be 40 percent. FIRE 623 Graded Case Assignment - Mid-Atlantic Container Corporation 100 points Due December 4, 2019 at 7:00 pm 1) Assess the current financial health and recent financial performance of the company. What strengths and/or weaknesses would you highlight to Sarah Conner? 2) What are the key driver assumptions of the firm's financial performance? What are the managerial implications of those key drivers? That is, what aspects of the firm's activities should Sarah Conner focus on especially? What is Mid-Atlantic's weighted average cost of capital (WACC)? What are the key assumptions that especially influence WACC? What are the free cash flows of the packaging machine investment? Should Conner approve the investment? Forecast the firm's financial statements for 2018 and 2019. What will be the external financing requirements of the firm in those years? Can the firm repay its loan within a reasonable period? Hint: You should analyze the packaging machine investment before forecasting the financial statements. NOTES: I am more interested in the quantitative analysis. Thus, your write-up should be (a) concise and to the point and (b) based on your quantitative analysis. The write-up should not exceed three (3) pages plus how ever many pages you need for your spreadsheet analysis. Make sure that I am able to follow your spreadsheets. That means to annotate and format appropriately. Your grade will be partly based on how you present the data to me. You may work in groups of up to 4 people on this project. EXHORT Historical income Statements scal year ended June 30. ligures in thousands of dollars) 2016 2017 2018 2019 Actual Actual Actual Actual $25 202 $28822 $34010539792 1 Sales Operating Expenses 2 Production costs and expenses 3 Administrative and selling expenses Deprecanon Total operating expenses 11 950 13.30 17.847 22335 5.734 5.957 7020 7.970 2375 2,367 2687 2,657 120 060) (21,714) (27 534) (32.972) 52 7 109 646682 (2427) 2.535) 3265) (3.222) 3.715 4574 3212 3.598 (1.647) (1 845) (1.269) (1.403) 2.000 2720 1943 2.195 1000 1000 1000 1000 $1.068 $1.7293943 1.195 3 E ings before the to common shares EXHIBIT 2 Historical Balance Sheets fiscal year ended June 30, gures in thousands of dollars) 2016 2017 2018 2019 (Actual) Actual Actual (Actual Assets $1.754 32040 $2.906 $1.540 2 Accounts receivable 8.113 9,125 10 311 13.316 15,851 17.147 25.043 34.717 4 Total current assets 25.738 28 312 38 859 49.573 5 Gross property plant & equit 23 567 28 687 20 657 28.867 5 Accumulated depreciation (2 505) (4372) 7.538) (10.205) 7 Net property plant seguit 21 162 21.796 19.129 18.462 Total assets 46.900 50.107 67 988 68.035 Liabilities and stockholders' equity 9 Short term borrowings (bank) 10 Accounts payable 11 Other current abilities 12 Total current liabilis 13 Long term deb 14 Shareholders' equity 15 Totlabs & Shir'e 12.000 13.042 19 680 25 802 4511 4,607 4,705 5328 9.0149414 9616 9723 25,585 27.083 34001 40 853 10.000 10000 10000 10 000 11.315 13.044 13987 15 182 $40 900 950 107 $57 988 586 035 Short-term bank debt ws borrowed from Yurbank at an interest rate equal to LIBOR 4 percent LIBOR (London Interbank Offered Rate) was a common benchmark for expressing the floating rate of interest on bank loans ** The company's long-term debt of $10 milion had been issued pively in 2015 to Bendini Lambert and Locke and to Carolina Pulp & Paper. This debt was subordinate to any bank debt outstanding EXHIBIT 3 Ratio Analysis of Historical Financial Statements (fiscal year ended June 30) 2016 (Actual) 2017 (Actual) 2018 Actual) 2019 (Actual) Profitability 1 Operating Profit Margin 2 Average Tax Rate 3 Return on Sales 4 Return on Equity 5 Return on Assets 23.4% 44.3% 7.9% 18 3% 4.4% 24.7% 40.3% 9.5% 20.9% 5.4% 19.0% 39.5% 5.7% 13.9% 3.4% 17.1% 39.0% 5.5% 14.5% 3.3% Leverage 2.36 6 Debt Equity Ratio 7 Debt/Total Assets 8 EBITAnterest (x) 1.95 0.47 2.53 1.77 0.46 2.80 2.12 0.51 1.98 0.54 2.12 Asset Utilization 9 Sales/Assets 10 Sales Growth Rate 11 Assets Growth Rate 12 Days in Receivables 13 Payables to COGS 14 Inventories to COGS 55.9% 40% 6.0% 113.0 37.7% 132.7% 57.5% 100% 6.8% 115.6 34.4% 128 2% 58.7% 18.0% 15.7% 110.7 26.4% 143.7% 60.3% 17.0% 13.9% 122.1 23.9% 155.4% Liquidity 15 Current Ratio 16 Quick Ratio 1.01 0 39 1.05 0.41 1.14 0.39 1.21 0.36 EXHIBITS Datson Com b ie Comories and Carital Market Conditions of Sales Cardboard B Name Dickensonic Nbre MS Pranings Valueline Book Book Value Price Outstanding Det er Share on Sharmillions 550 S10 DO 50 1.30 070 1275 18.00 15 0 2000 25 CO 000000 5-Year Arms Earrings Grow Dand 50 95 $100 305 5000 52.20 Don ISBEX Carp ZEPORT Recently Renes s 2019 Coco Mar Camcunda Price LO US Trys US Treasury Bills US Treasury His US Treasury Bill US Toy Bonds US Treasury on 2016 year 5 year Semana Dickerson le Han beshe Donaldson no 000x Corp REPORT 50% 604 150 2 2020 2031 10.04 9341 01.08 9031 30 Historical Fury Note Face value on all bonds Premium 100 Amor Me Gemeen Desconal Companes Dickerson me The company was founded 50 years ago you can Detot no major business actores enorcaty have been production of packsong cacer trycy entered the candid chan Han hal This company was a sis off from a large conglomerate in 1978 Although the many we d er in the producton of cardboard boves the recent suffered decline in sales infighting among the prinopal owners has lod concern about the forme prospects Donde They founded only two w ere sa com and its s e is about the same t h of carbon IBEX Corp This company has recenty been an innovator in the production of cardboard Amough c heard box a tacuring is not a business paper bag manucuring the company is reeds beam competitor in the next The company was an early poneer in the cardboard box nauntry Recently however began to invest in now areas and has been moving away from cardboard production is a focus of business ZEPORT Mid-Atlantic Container Corporation: Some Financial Concerns On August 25, 2019, her first day as chief executive officer (CEO) of Mid-Atlantic Container Corp. (Mid-Atlantic, Sarah Conner confronted a host of management problems at the company. One week earlier, Mid-Atlantic's president and CEO had been killed in a tragic accident. Soon thereafter, Sarah was appointed to fill the position - starting immediately. Several issues in her in-box that first day were financial in nature, either requiring a financial decision, or with outcomes that would have major financial implications for the firm. That evening. Conner asked to meet with her assistant, Louis Tane, to begin addressing the most prominent issue MID-ATLANTIC CONTAINER CORPORATION AND THE CARDBOARD BOX AND CONTAINER MANUFACTURING INDUSTRY The Mid-Atlantic Container Corporation had been founded as a joint venture between Carolina Pulp & Paper and a venture capital firm. Bendini, Lambert and Locke (BLL) Mid-Atlantic's sole business mission was to manufacture boxes from cardboard packaging known as corrugated Fiberboard. Mid-Atlantic served as a supplier of cardboard boxes to other manufacturing firms in the Eastern US. and was known for producing some of the best cardboard packaging material in the industry Given its ubiquity in packaging, revenue for the global cardboard box and container manufacturing industry is highly correlated with global demand from manufacturing and retail sectors. The industry is highly fragmented with an estimated 15,700 companies operating in the industry (globally) and only 4 companies controlling more than 1.0% of the market. The majority of companies operate locally or regionally, providing cardboard boxes to companies within a relatively short distance from their facilities. Barriers to entry are relatively low: a new, small plant would cost between $8 million and $10 million. Easy entry had led to price competition in recent years among cardboard box manufacturers. One analyst said, The gross margins on cardboard boxes have eroded tremendously over the past five years. I don see there's any more manenvering left on the price. Despite deteriorating demand in the overall US market for cardboard packaging material. Mid-Atlantic's growth prospects looked bright. At the regional level, demand was strong and Mid-Atlantic's focus on customer service and quality products had resulted in a strong and expanding customer base. FINANCIAL QUESTIONS FACING SARAH CONNER That evening, Conner met with Louis Tang, a promising new associate whom she had brought along from BLL. Sarah's brief discussion with Louis went as follows: Sarah Back at BLL we looked at Mid-Atlantic as one of our most promising venture capital investments. Now it seems that such optimism may not be warranted - at least until we get a solid understanding of the firm's past performance and its forecasted performance. Did you have any success on this? Louis Yes, the bookkeeper gave me these: the historical income statements Exhibit 1 and balance sheets Exhibit 2) for the last four years. The accounting system here is still pretty primitivellowever, I checked a number of the accounts, and they look orderly, Sol suspect that we can work with these figures. From these statements, I calculated a set of diagnostic ratios Exhibit 31. Sarah: I see you have been busy. Unfortunately, I can't study these right now. I need you to review the historical performance of Mid-Atlantic for me, and to give me any positive or negative insights that you think are significant Louis When do you need this? Sarah At 7:00 A.M. tomorrow. I want to call our banker tomorrow morning and get an extension on Mid-Atlantic's loan. Louis: The banker, Mr. Farmington, said that Mid-Atlantic was "growing beyond its financial capabilities." What does that mean? Sanak: It probably means that he doesn't think we can repay the loan within a reasonable period. I would like you to build a simple financial forecast of our performance for the next two years ignore seasonal effects and show me what our debt requirements will be at the fiscal years ended 2020 and 2021. I think it is reasonable to expect that Mid-Atlantic's sales will grow at 15 percent each year. Also, you should assume capital expenditures of $8.4 million for plant renovations spread out evenly over the next two years and depreciated over five years on a straight-line basis. Use whatever assumptions seem appropriate to you based on your historical analysis of results. For this forecast, you should assume that any extemal funding is in the form of debt. Louis: But what if the forecasts show that Mid-Atlantic cannot repay the loan? Sarah: Then we'll have to go back to Mid-Atlantic's owners, BLL and Carolina Pulp & Paper for an injection of equity. Of course, BLL would rather not invest more funds unless we can show that the retums on such an investment would be very attractive, and/or that the survival of the company depends on it. Thus, my third request is for you to examine what returns on book assets and book equity Mid-Atlantic will offer in the next two years and to identify the "key driver" assumptions of those returns. Finally, let me have your recommendation about operating and financial changes I should make based on the historical analysis and the forecasts. Louis: The plant manager revised his request for a new packaging machine and thinks these are the right numbers (see the plant manager's memorandum in Exhibit 4) Essentially, the issue is whether to invest now or wait three years to buy the new packaging equipment. The new equipment can save significantly on labor cost but carries a price tag of Si million. My hunch is that our preference between investing now versus waiting three years will hinge on the discount rate. Sarah [laughing) The joke in business school was that the discount rate was always 10 percent. Benedini, Lambert and Locke owned a 60 percent interest in the equity of Mid-Atlantic and Carolina Pulp & Paper owned the remaining 40 percent interest. EXHIBIT 1 Historical Income Statements (fiscal year ended June 30; all figures in thousands of dollars) 2016 2017 2018 2019 (Actual) (Actual) (Actual) (Actual) $26,202 $28,822 $34,010 $39.792 Sales Operating Expenses: Production costs and expenses Administrative and selling expenses Depreciation Total operating expenses Operating income Interest expense Earnings before taxes Income taxes Net earnings Dividends to all common shares Retention of earnings 11,950 5,734 2,376 (20.060) 6,142 (2.427) 3,715 (1.647) 2,068 1.000 $1,068 13.380 17.847 22,335 5,967 7,020 7.970 2,367 2,667 2,667 (21.714) (27.534) (32,972) 7.109 6,476 6,820 (2,535) (3,265) (3.222) 4,574 3,212 3,598 (1,845) (1,269) (1.403) 2.729 1.943 2,195 1.000 1.000 1.000 $1,729 $943 $1,195 EXHIBIT 2 Historical Balance Sheets focal year ended une 30 ml figures in thousands of dollars) (Actual) Actual Actual (Actual Assets Cash Accounts recevable Inventions Total current assets Gross property at & equit Accumulated deprecation Net property plant Beguit To assets $1.754 52000 52.905 51 540 3.113 125 10 311 13 316 15 851 17,147 25 543 34 717 25 738 28.312 38 85949573 23.667 26.687 25 687 25.667 2 505) (4 872) 7.538) (10.205) 21.162 21.795 19.129 16,462 46.900 50.10757.958 66035 Labtes and stockholders' equity Short term borrowings (bank) Accounts payable Other current liabilities Total current liabilities Long term debi Shareholders' equity Total labs & strids'eg 12.060 4,511 9.014 25 585 10.000 11.315 $46 900 13.042 19,680 25.802 4.607 4.705 5.328 9.414 9.616 9.723 27 063 34 001 40.853 10.000 10000 10000 13.044 13 987 15.182 $50,107 $57.968 566,035 Short-term bank debt ws borrowed from Yurbank an interest rate equal to LIBOR 4 percent. LIBOR (London Interbank Offered Rate) was a common benchmark for expressing the floating rate of interest on bank loans ** The company's long-term debt of $10 million had been issued privately in 2015 to Bendini, Lambert and Locke and to Carolina Pulp & Paper. This debt was subordinate to any bank debt outstanding EXHIBIT 3 Ratio Analysis of Historical Financial Statements (fiscal year ended June 30) 2016 2017 (Actual) [Actual) 2018 2019 Actual) (Actual) Profitability 1 Operating Profit Margin 2 Average Tax Rate 3 Return on Sales 4 Return on Equity 5 Return on Assets 23.4% 44.3% 7.9% 18.3% 4,4% 24,7% 40,3% 9.5% 20,9% 5,4% 19.0% 39.5% 5,7% 13.9% 34% 17.1% 39.0% 5,5% 14,5% 3,3% Leverage 6 DebvEquity Ratio 7 Debt Total Assets 8 EBIT/Interest (x) 1.95 0.47 2.53 1.77 0.46 2.80 2.12 0.51 1.98 2.36 0.54 2.12 Asset Utilization 9 Sales/Assets 10 Sales Growth Rate 11 Assets Growth Rate 12 Days in Receivables 13 Payables to COGS 14 Inventories to COGS 55.9% 4.0% 6,0% 113.0 37.7% 132.7% 57,5% 10.0% 6.8% 115.6 34,4% 128.2% 58.7% 18.0% 15,7% 110.7 26.4% 143.7% 60.3% 17.0% 13.9% 122.1 23.9% 155.4% Liquidity 15 Current Ratio 16 Quick Ratio 1.01 0.39 1.05 0.41 1.14 0.39 1.21 0.36 EXHIBIT 4 O'Rourke's Memo Re: New Packaging Equipment MEMORANDUM FROM Sa Corr. President and CEO Mid-Atlantie Container Corporation Haney O'Rourke. Plant Manager August 10, 2019 New Packaging Equipment SUBJECT: Abhough our hox packagun equipment is adeguale al current production levels, it is terribly inefficient The new machinery on the market can give us significantlabor savings as well as increased flexibility with expect to the type of packaging I recommend that we go with the new technology. The considerations relevant to the decision are included in this memo Our current packaging equipment was purchased five wars ago as used equipment in a liquidation sale of a small company. Although the equipment was inexpensive, it is slow, requires constant monitoring, and is frequently shut down for repairs. Since the packagine quipment is significantly slower than the production equipment, we routinely have to use overtime labor to allow packaging to catch up with production. When the packager is down for repairs, the problem is acerbated and we may spend several two-shin days catching up with production. I can say that we have missed any deadlines because of packaging problems, but it is a constant concern around here and things would run a lot smoother with more reliable equipment. In FY 2020 we will pay about $5.000 per year for maintenance costs. The operator is paid $30,000 per year for his regular time, but he has been averaging $40,000 per year because of the overtime he has been working. The equipment is on the tax and reporting books at $120,000 and will be fully deprecated in three years' time (we are currently using the straight-line depreciation method for both tax and reporting purposes and will continue to do so. Because of changes in packaging technology, the equipment has no market value other than its worth as scrap metal But its scrap value is about equal to the cost of having it removed. In short, we believe the equipment has no salvage value at all. The packaper offers many advantages over the current equipment. It is faster, more reliable, more flexible with respect to the types of packaging it can perform and will provide enough capacity to cover all our packaging needs in the foreseeable future with suitable maintenance, we believe the packager will operate indefinitely. Thus, for the purposes of our analysis, we can assume that this will be the last packaging equipment we will ever have to purchase. Because of the anticipated growth at Mid-Atlantis, the current equipment will not be able to handle our packaging needs by the end of 2022. Thus, if we do not buy new packaging equipment by this year's end, we will have to buy it after three years time anyway. Since the speed, capacity and reliability of the new equipment will eliminate the need for overtime labor, we feel strongly that we should buy now rather than wait another three years The new equipment currently costs sl million, which we would depreciate over 10 years $100.000 per year. It comes with a lifetime factory maintenance contract that covers all routine maintenance and repairs at a price of $2.000 for the initial year. The contract stipulates that the price after the first year will be increased by the same percentage as the rate of increase of the price of new equipment. Thus, if the manufacturer continues to increase the price of new packaging equipment at 5 percent per annum as it has in the past, our maintenance costs will rise by 5 percent also. We believe that this sort of regular maintenance should ensure that the new equipment will keep operating in the foreseeable future without the need for a major overhaul. Mid-Atlantic's labor and maintenance costs will continue to rise due to inflation at approximately 2 percent per year over the long term. Because the manufacturer of the packaging equipment has been increasing its prices at about 5 percent per year, we can expect to save $157,625 in the purchase price by buying now rather than waiting three years. The marginal tax rate for this investment would be 40 percent